Hit 'em Where They Ain't
By S.P. Brown

Wee Willie Keeler was a 19th century outfielder for the National League Baltimore Orioles (save the e-mails, I know today's Orioles are an American League team, back then they plied their trade in the National League). Keeler was best known for his diminutive size (5', 4"), his .341 batting average, and his aversion to striking out; he once posted 520 straight plate appearances with only six strike-outs. When asked about his hitting prowess, Keeler replied, "I keep my eyes clear and I hit 'em where they ain't."

Sadly, Wee Willie is no longer with us (Keeler gave up the ghost in 1923), but his sagacious advice lives on, or so you would think.

Oddly, few ball players willing embrace the Keeler baseball hitting philosophy. In fact, after observing the Colorado Rockies post their 56th lost of the season, I thought they were thumbing their collective noses at Wee Willie, for rarely had I seen a more cloudy-eyed bunch hitting so many balls to where they are.

This got me to thinking. Baseball players aren't the only ones hitting 'em were they are, many investors are, too. How else can you explain folks piling into Qualcomm (QCOM) at $200, Commerce One (CMRC) at $165 and Citrix (CTXS) at $122?

Unfortunately, this strategy works no better in investing than it does in baseball. An insomnia-curing study published by academicians Eugene Fama and Kenneth French confirms that buying stocks with low price-to-earnings (P/E) and book-value- to-market-value ratios is superior to buying the opposite. In other words, buying out of favor stocks beats buying the trend over the long-term (keep in mind, I'm using "long-term" literally here, meaning years, not hours).

If you're new to investing, ignoring the trend would appear to be financial suicide. After all, momentum investing has been the rage over the past few years, easily producing 300 to 400 percent gains, particularly in the tech sector, where it seems everything has made for the stratosphere.

Look no further than everyone's favorite, Cisco Systems (CSCO). Clearly, investors have been hitting nothing but pop-flies to the king of all Internet routers over the past few years. The company's stock has advanced nearly 450 percent from $15 a share in October 1998 to $82 in March 2000 (the stock has since eased to $66 and change). During this time, Cisco's earnings- per-share (EPS) advanced 155 percent, while its revenues doubled. More impressively, this growth hasn't come at the expense of operating margins; gross margins have held at 65 percent, while net margins have held at 15 percent.

Obviously, Cisco is a fast growing, efficiently run operation, but does that necessarily make it a potentially profitable investment? I'm not so sure. Great companies don't always equate to great investments. At its current price of $66 and change, Cisco is certainly richly priced, trading at 23 times book value and 185 times trailing twelve-month earnings.

What's more, Cisco is going to have to peddle awfully hard in the future to maintain its princely valuation. Using fiscal year 1999 earnings of $2.1 billion as a base, the company will need to continue growing earnings at a 31 percent clip for the next ten years, and then at 12 percent clip thereafter, to justify its current price when using a 6 percent discounting rate (the 30-year Treasury-bond rate). Should the earnings growth rate falter, or the discount rate rise, Cisco could be in for a world of hurt.

For example, should Cisco's earnings growth rate fall to 20 percent, the company's net-present value falls to $27 a share, which isn't entirely unreasonable. Keep in mind, Cisco is now growing from a much larger base than it has in the past; the company is likely to post revenues of $18 billion for fiscal year 2000. Also, over the trailing twelve-month period, EPS growth has slowed to 27 percent compared to its five-year average annual rate of 38 percent.

Now, take a look at the end of the spectrum, where investors have the field all to themselves.

Is there any industry disliked more than tobacco? Consider U.S Tobacco (UST). It's a vilified 100 year-old relic that can't buy a kind word on Wall Street. Furthermore, the company's stock has been circling the drain for the past 30 months, going from $30 to $15 a share.

Nevertheless, despite the anemic stock performance, U.S. Tobacco is growing revenues and earnings. Over the October 1998 to the August 2000 period, revenues grew 12 percent while EPS grew 13 percent. Yes, U.S. Tobacco is growing at a much slower pace than Cisco, but does that necessarily make it an inferior investment?

Like Cisco, U.S. Tobacco is a well-run operation. The company sports Microsoft-like gross and net margins of 80 percent and 30 percent, respectively. Additionally, like Cisco, it rules its niche, holding a 76 percent share of the highly profitable smokeless tobacco market.

Applying the same net-present value calculations to U.S. Tobacco, it appears as if U.S. Tobacco is a screaming bargain. If we assume initial earnings of $469 million (fiscal year 1999), a paltry annual EPS growth rate of 0.94 percent and a discount rate of 15.00 percent (a higher discount rate is warranted because of higher business risk), we arrive at a net present value for the company's next 10 years of earnings of $2.45 billion. From 10 years to infinity, we'll then assume an earnings growth rate of 6 percent and a discount rate of 12 percent (I'm assuming the trial lawyers will have retracted their claws by then). Based on these conservative assumptions and after subtracting long-term debt, U.S. Tobacco has a net- present value of $25 a share, a 67 percent premium to its current price of $15.

Of course, there is no guarantee that U.S. Tobacco will prove to be the better value. However, if the past is any indication of the future (there's no reason to believe it won't be when it comes to human behavior), a portfolio of U.S. Tobaccos should prove to perform better than a portfolio of Ciscos over the long-run.

Finally, 100 years from now, when most of us have joined Wee Willie Keeler in the great-beyond (I say "most" because maybe, just maybe, one of those biotech companies will deliver more than blue-sky), I'll bet that U.S Tobacco will still be plugging along peddling its chewing tobacco, while Cisco Systems will either be a distant memory or an unrecognizable incarnation of what we now know.

For now, though, if you're a long-term investors, it might be best to start hitting 'em where they ain't, and that means swinging at the likes of U.S. Tobacco.